Last week, I explained that IRAs (and 401Ks, and 403Bs, and, I assume, the new MyRAs) help people time their taxes but not avoid taxes altogether. (IRAs and 401Ks are not for tax avoidance. They are for tax timing.) (Like I did last week, I’ll write about IRAs, but I mean to include 401Ks, 403Bs, etc. I just don’t want to repeat all of the different names for these accounts over and over in my writing.) I tried to explain how to withdraw the assets of the your tax-deferred account over 3 to 10 years (depending on the size of your IRA.) To clarify my advice, I want to consider how keeping too much money in your IRA can cost you or your family more in taxes.
Many people take out the Required Minimum Distribution (“RMD”) and no more. That RMD is calculated to have the IRA last as long as your life expectancy, i.e., the “average” life expectancy for someone 70 1/2 years old. (Roth IRAs do not have the same RMD requirements.) A life expectancy pay-out makes sense because IRAs were created to support retired people during their retirement to the end of their lives. IRAs were not created as a way to pass money to a retiree’s children and grandchildren (assuming that is who most retirees will name as their IRA beneficiaries.) The money in the IRA is supposed to be used up before you die — if you’re the “average” person with an “average” lifespan.
If you have better than average investments that provide more growth or income than “average,” your RMD won’t empty your account before your life expectancy. A well-invested IRA will leave money to your beneficiaries.
Similarly, if you die before your life expectancy (i.e., you’re unhealthier or unluckier than the “average” person,”) your IRA will still have money in it because you didn’t reach your life expectancy. Your beneficiaries will get your left over IRA money.
So, why is it bad if your children or grandchildren get money from your IRA? It’s bad because of taxes, of course. The beneficiaries of your IRA will have to pay the taxes on the IRA money. They can choose to spread out the payments (like an RMD) and, as a result, spread out the taxes the same way that I suggest you spread them out. Even with spread out payments, though, your beneficiaries will probably pay more taxes than you would have paid.
Your beneficiaries will probably pay more in taxes because, after your death, your beneficiaries will probably be in a higher tax bracket than you were before your death. Your children may still be working at the time of your death. Your grandchildren will almost certainly be working at the time of your death. The added income from your IRA will get taxed at your children’s or grandchildren’s top tax rate or maybe even push them into a higher tax bracket.
For example, you might be in the 15% tax bracket during retirement. (I’m not including state taxes in this discussion. There’s too much variation.) One dollar in your IRA is worth 85 cents to you after withdrawal. At the same time, your still-working children and grandchildren could easily be in the 25% tax bracket. Someone in the 25% tax bracket receiving one dollar of your IRA will get only 75 cents after taxes. That’s an extra 10% loss in money because you left untaxed money to someone with a higher income than yours. That extra tax loss will be worse for children and grandchildren in the 28%, 33%, 35%, and 39.6% tax brackets.
Unless your children and grandchildren are in the same or lower tax bracket as you (and stay in that tax bracket for the foreseeable future,) your family will lose more money from your IRA if you leave it behind than you would lose if you withdrew it yourself. And it’s rare for a children and grandchildren to be in lower tax brackets than their retired parents and grandparents.
In addition, tax rates are (from a historical perspective) pretty low right now. It’s likely that the tax rates will be higher in a few years. Money withdrawn now will have the benefit of today’s low tax rates. Money withdrawn (by you or by your children or grandchildren) after rates go up will be taxed at those higher rates.
So, I repeat my advice: Take your money out of your IRA during the first 3 to 10 years after retirement. Don’t leave money in your IRA to your heirs. Leave them money outside your IRA instead. If you manage the withdrawal of your IRA, the whole family will lose less money overall to taxes.
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